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have
been affected by it, detrimentally in this case.
The spillover effects may either impose a cost or create a benefit for external parties.
When the spillover effects are harmful, they are called external costs. Because costs are
imposed on nonconsenting parties, resources may be used to produce
goods that are valued
less than their full production costs, and inefficiency results.
Consider the production of paper. The firms in the market purchase trees, labor, and
other resources to first produce pulp, and then paper. The manufacturing
process may emit
pollutants into the atmosphere that impose costs on residents living around the mills—the
smell caused by sulfur, the organic compounds that contribute to smog, and even pollutants
that can cause paint on buildings to deteriorate. Such pollutants may make it difficult for some
people to breathe normally and perhaps cause other health hazards.
If the residents living near a pulp mill can
prove they have been harmed, they could
take the mill to court and force the paper producer to cover the cost of their damages. But it
will often be difficult to prove the harm and that the pulp mill is responsible. When this is the
case, the costs they experience will not be reflected through markets and, therefore, the cost of
producing paper will be understated. Inefficiency occurs because units of paper will be
produced that are valued less than the costs of their production, including the external costs.
To
a large degree, external costs reflect a lack of fully defined and enforced property
rights. Because the property right to a resource—clean air for example—is poorly enforced,
the firm does not pay the full cost of using the resource. Thus, the cost of producing goods and
services using such resources is understated.
Sometimes the spillover effects will generate benefits for others. When the spillover
effects enhance others’ welfare, they are called external benefits. But external benefits can pose
problems
for markets, too. When the persons or firms that generate the external benefits are
uncompensated, they may fail to produce some units even when they are valued more than
their production costs.
For example, suppose a pharmaceutical company develops a vaccine providing
protection against a deadly virus. The vaccine can easily be marketed to consumers who will
benefit directly from it. However, because of the communal nature of viruses, as more and
more people take the vaccine, those who haven’t bought the vaccine will also be less likely to
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catch the virus. Yet it will be very difficult for the pharmaceutical
companies to capture the
benefits derived by the nonusers. As a result, they may produce too little of the vaccine. Thus,
when external benefits are present, market forces may supply less than the amount consistent
with economic efficiency.
Perhaps the government should take action. In the case of external costs, a tax imposed
on the activities that generate the external costs might lead the person or firm to reduce its
activities and achieve an output level more consistent with economic efficiency. Similarly, in
the case of external benefits, government subsidies might spur production, resulting in a more
efficient output level.
The potential adverse consequences of externalities can sometimes be controlled
without government, however. In the case of external benefits, entrepreneurs have an incentive
to figure out ways to capture more fully the gains their actions generate for others. The
development of golf courses illustrates this point. Because of the beauty and openness of golf
courses, many people find it attractive to live nearby. Thus, constructing a golf course typically
generates an external benefit—an increase in the value of the nearby property. In recent years,
golf course developers have figured out how to capture this benefit. Now, they typically
purchase a large tract of land around the planned course before it is built. This lets them resell
the land at a higher price after the golf course has been completed
and the surrounding land has
increased in value. By extending the scope of their activities to include real estate as well as
golf course development, they are able to obtain revenues from what would otherwise be
external benefits.
As for external costs, simple rules can help control them. For example, with respect to
noise from nearby residents, apartment owners often have rules about playing loud music late
at night and they enforce the rules by expelling violators. Manners and social conventions can
also play a role. If your roommates are aware that having the television on interferes with your
studying, they may have the good manners to turn it off. More broadly,
over time it has
become “socially unacceptable” for companies to emit pollution that harms people and their
environment. There is increasing pressure for companies to be good citizens—and private
watchdogs such as environmental groups will publicize their actions if they behave
irresponsibly.
